Thursday, April 23, 2009

America's Hottest Sector: Casual Dining Restaurants.

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The longer you around the market, the more you begin to see things you'd never imagine. The largest banks in the country trading like penny stocks, fertilizer stocks trading like internet IPOs circa 1999, and now the hottest momentum sector in America - casual dining restaurants. This was a group I was negative on back in 2007 [Sep 19, 2007: Tough Times Ahead: Restaurants?] before it was cool to be a bear.

Middle class consumer squeezed along with skyrocketing inputs for their food doesn't bode well for profit margins in this group as a whole. We have the cheese inflation, the dairy inflation, the corn inflation and now the wheat inflation.

In general the thesis was we are going to enter a monster of a recession (at the time the punditry was denying a recession was even possible ... after all the "all knowing Oracle" called the stock market was at all time highs and its the best forecasting tool on Earth) and food inflation was going to be a huge issue [Oct 31, 2007: Food Inflation Starting to Hit Restaurants] - which also came true. [Dec 19, 2007: Darden Restaurants Weak - Another "Tell" Stock] This obliterated margins in the restaurant space by summer 2008.

Back in 2007/2008 we could not short individual names, but I pointed out Ruby Tuesday's (RT) to readers as a highly leveraged name back when it was just under $20. [Ovt 11, 2007: Let's Check in on Ruby Tuesday] It eventually fell to BELOW $1. (full disclosure - even if I could of shorted I would of covered well before $1 - I never expected it to fall THAT far) Too bad we could not of taken that trade. Now it's started making the full round trip and back from $1s to $8s. Oh, to of been long the Ruby two months ago...

Many chains have just hung it up [Jul 30, 2008: Bennigan's Stake & Ale Files for Bankruptcy] - which actually will be a net positive for the survivors once the economy gets back to "solid". Thankfully, breastaurants never suffered! [Mar 8, 2009: ABC News - Business Booming at Breastaurants - Hooters, Bone Daddy's, Twin Peaks] Some things are indeed recession proof.

But in latter February 2009 we had come full circle; I began to see some of the leadership stocks in this group diverge from the rest of the market - as discussed in this week's earnings preview [Apr 19: Flood of Earnings Begin - Monday/Tuesday Preview]

Brinker (EAT) - one of the best charts out there for this restaurant stock, and I blame myself for not catching this one early. While the rest of the market was imploding mid Feb 09 through very early March, the restaurant stocks were diverging and holding steady with small drops and lots of sideways action. This was an early sign to jump in because once the market steadied these should have been leaders - and they have been. EAT has risen nearly 100% in just 6 weeks.


Now we've seen explosive moves across the group, from worst to best of breed. As always the biggest gains actually came from buying the most speculative stocks below $5, but even the big guns and former mo mo named like Chipotle Mexican Grill (CMG) are running like potash stocks of fall 2007 or Lycos / Excite /AtHome (heard of those?) circa fall 1999. Unlike most of the discretionary spending stocks that are running on the "green shoot" economy, I can at least get behind the thesis in these stocks since a $11 meal is different than a $600 washer or $17,000 motorcycle. Americans can scrounge around for that extra $11, especially with the help of the Ben Bernanke House Atm v6.0. But once again, after these massive runs - valuations are now getting very heady. Most are making their numbers not through normal growth, but simply a huge swoon in commodity prices (reversing last year's spike) and cutting jobs. Same store sales are down in most cases.

I continue to be a fan of Buffalo Wild Wings (BWLD),[Feb 23: Buffalo Wild Wings with Saucy Report] Panera Bread (PNRA) and at the right valuation Chipotle (CMG) - good managements who are executing and they are differentiated and priced at the right level for the long slog we are heading to... aka the green shoot recovery.


Much like the Las Vegas casinos we highlighted yesterday, the highest risk reward lies in the low priced, heavily in debt stocks - so it is again a decision of how much trust you have in said recovery, and where you want to place your risk/reward. And frankly, right now we live in a student body left/right atmosphere (it's the quant fund era!) so you can throw a dart at most any stock in a sector and get the same result. Every stock in the sector is the same stock to HAL9000 - the charts all look the same, it is just the magnitude of the move that differs somewhat.


Now what is interesting is bulls can have their cake and eat it too - commodities dropped off a cliff (pricing) vs a year ago because of global recession. So if you want to have global recovery does not that include a pick up in commodity prices? Apparently not in the Goldilocks, green shoot economy.
  • "The casual dining numbers, we're seeing aren't good numbers; they're just less bad," said Stifel, Nicolaus & Co analyst Steve West. "Less bad is the new good."
I can imagine the conversation going on in American households across the nation. "Johnny, I want you to grow up and be the best you can be - strive to be less bad!"

The other thing I am noticing in company after company whose year over year results are quite awful but "better than expected" as many of the gains are coming from "streamlining" i.e. chopping people left and right. That's great - except for the small part that eventually you chop away many of your customer's ability to ... buy motorcycles, refrigerators, homes, eat out, etc. That was the whole basis for the Henry Ford high wage (for the time) for his line workers - he wanted to have workers that could actually buy the cars they made (of course that was before the days of easy money and 0.0% 72 month loans) How times have changed! Instead of the natural ability to afford things, we instead have easy central bankers spreading new money the world over. A generous people they are...

So I do find it ironic; Wall Street will smartly take stocks up on these "cost containment's" while Main Street looks around with the ax falling on their head left and right. 2 Worlds. So what will be interesting in my eyes is what happens later in 2009 and into 2010, if my ideas of a double dip recession plays out. All the easy "cost savings" (humans) will be complete, and commodities will potentially be higher if the Uncle Ben printing press "achieves success". Then what? And I really asking that in a more general term.... not so much specific to the next 6-12 months, or pertaining to restaurants - but I am asking that in a much larger sense as a society where most citizens has been suffering through stagnating wages for a decade and whose only defense is printing more money and handing it out as compensation. [Dec 8, 2007: Do the Bottom 80% of Americans Stand a Chance?] Keep the balls juggling in the air, until the music stops.

I asked Michael Brisky from In the Know blog to give an assist to this post to flesh out the results of a few names that reported this week - Brinker (EAT), PF Chang's China Bristo (PFCB), and Chiptole (CMG) to add some flesh to the bones I laid out below - here is his take - and remember Chipotle is actually an outlier as it's a hot trendy newer concept that has a top notch management - unlike most of the casual restaurant space their same store sales are still north of 0%. I took a look at a lot of the results from other chains and its the identical playbook: faltering same store sales, but profit higher than expected due to cost containment both human and commodity. Once the momo stops in this sector, there are going to be some excellent short opportunities - we need a nice ETF for this group.

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With earnings season well underway, we're getting a good look as to how the consumer is responding to the current economy. Surprisingly, casual chain restaurants are coming in with strong earnings. Is this a trend or mirage? Lets take a look at the numbers.

PF Chang's China Bistro (PFCB) reported earnings yesterday:
  • Restaurant chain P.F. Chang's China Bistro Inc. said Wednesday its first-quarter profit rose nearly 33 percent even as traffic continued to decline at both of the company's restaurant chains. The Scottsdale, Ariz., company also raised its 2009 full-year profit guidance.
  • For the quarter ended March 29, net income climbed to $13.7 million, or 56 cents per share, from $10.4 million, or 41 cents per share, a year earlier. Analysts polled by Thomson Reuters expected profit of 33 cents per share.
  • Sales at the company's namesake chain fell less than 1 percent while revenue at the smaller Pei Wei Asian Diner rose 7 percent. The company said both concepts saw a decline in guest traffic. Same-store sales, or sales at locations open at least a year, fell 6.6 percent at the Bistro and dropped 2.2 percent at Pei Wei.
  • P.F. Chang's said the company will likely continue to see sliding sales through the rest of 2009. The company predicted total revenue for the year will fall 1 percent to 2 percent. But the company still boosted its 2009 profit guidance, saying it now expects earnings per share between $1.45 to $1.50 due to the likely impact of "operational improvements."
How about Chipotle Mexican Grill (CMG)?
  • Chipotle Mexican Grill Inc. said Wednesday its net income rose nearly 47 percent in the first quarter, handily beating Wall Street estimates, as the company benefited from price increases implemented at its restaurants late last year.
  • Chipotle said it earned $25.4 million, or 78 cents a share, in the period ended March 31. That was up from earnings of $17.3 million, or 52 cents a share, in the same period last year.
  • Analysts predicted the Denver-based company would earn 55 cents a share on slightly higher revenue of $360.2 million, according to Thomson Reuters.
  • Chipotle said the revenue increase was largely due to price increases it implemented at its restaurants in late 2008, and from the 26 new restaurants it opened in the quarter. Comparable restaurant sales grew 2.2 percent due to the increased pricing, even as the company experienced a drop in foot traffic.
Also reporting today is Brinker International (EAT):
  • Shares of Brinker International Inc. took off Wednesday as analysts extolled the cost-cut-driven profit the restaurant operator posted the day before.Dallas-based Brinker, which runs Chili's Grill & Bar and other chains, said on Tuesday it earned $35 million, or 34 cents per share, in its fiscal third quarter, despite a double-digit drop in revenue.
  • Goldman Sachs analyst Steven Kron on Wednesday upgraded Brinker to "Buy" from "Neutral," saying Brinker's "paradigm shift in cost structure" will continue to drive profit margins higher. He said the company's cost savings will spark profit margin gains despite continued drops in same-store sales, a key retail indicator that measures sales changes in stores open at least a year. Cost-saving measures include lower expenses to open shops, pre-portioned serving sizes for food, more active negotiations with suppliers, and leaner management, Kron said.
These stocks have all been moving much higher. Others in the sector, such as Buffalo Wild Wings and Panera Bread, will report next week, but the results are expected to be similar. Additional names moving higher are Famous Daves and Darden Restaurants. So what are the positive catalysts here?

A) Consumers have been "trading down" from more expensive options to value priced chain restaurants in their neighborhood. We've seen this happening in many other areas of retail as well. If the economy continues to deteriorate, consumers may "trade down" further to fast food and cooking at home. Some of this is already happening if you look at McDonald's sales.
B) These guys are cutting costs to be competitive. They are running food specials and operating on reduced staff.
C) Raw food costs are likely lower than a year ago as commodity prices have dropped.

The negative catalysts are pretty obvious:

A) Difficult economy and job market is causing people to eat out less.

The analysts on these stocks are coming up with opposing viewpoints, and I have to question Steve Kron's statement of "(the) paradigm shift in cost structure will continue to drive profit margins higher." To that I say okay, for now it will. That's great they have improved their cost structure, but you still need revenue, don't you?

The thing to keep an eye on here is same store sales. PF Chang's showed a drop of 6.6 percent. If that trend continues, then earnings strength cannot be sustained. Right now they are benefiting from "operational improvements" AKA cutting costs, but you can only do this for so long.

Analyst Steve West has a little different opinion on the cost cutting measures:

"The casual-dining segment has had horrible comps and they're compensating with cost savings, but they can't sustain that past a few quarters," West said. "If they can't post strong comps, then it will all fall apart."

My Take: Its all going to come down to employment, and the level of disposable income and confidence consumers have. You can go right down the line with these restaurants, and their stocks are all moving higher. Much higher. Sure, they can report good numbers for a quarter or two by shuffling prices. But without growth in same store sales, these levels of earnings growth aren't sustainable over longer periods of time. Stock wise, you have to respect the trend and let them run higher through earnings announcements, but I'd say there will be an opportunity to short these names in coming months. Especially so if consumer sentiment stays weak.

Author has no positions in above names.

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